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Equity Equity FinancingFinancing

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Learning Objectives

1. Identify the rights associated with ownership of common and preferred stock.

2. Record the issuance of stock for cash, on a subscription basis, and in exchange for noncash assets or for services.

3. Use both the cost and par value methods to account for stock repurchases.

4. Account for the issuance of stock rights and stock warrants.

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Learning Objectives5. Explain the difference between the intrinsic

value and fair value methods, and use both in accounting for a fixed stock option plan.

6. Distinguish between stock conversions that require a reduction in retained earnings and those that do not.

7. List the factors that impact the retained earnings balance.

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Learning Objectives 8. Properly record cash dividends, property dividends, small and large stock

dividends, and stock splits. 9. Explain the background of unrealized gains and losses recorded as direct equity

adjustments, and list the major types of equity reserves founds in foreign balance sheets.

10. Prepare a statement of changes in stockholders’ equity.

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Learning Objectives

11. Eliminate a retained earnings deficit through a quasi-reorganization.

12. Use both the intrinsic value and fair value methods to account for performance-based stock option plans and plans calling for a cash settlement.

EXPANDED MATERIAL

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LegalCapital

AdditionalPaid-InCapital

Components ofStockholders’ Equity

RetainedEarnings

ContributedCapital

Other

Stockholders’Equity

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Common Stock

The owners of common stock of a corporation can be thought of as the true owners of the business.

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Common Stock

Unless restricted by terms of the articles of

incorporation, the common stockholder has certain

basic rights.

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The right to vote in the election of directors and in the determination of certain corporate polices such as the management compensation plan or major corporate acquisitions.

The right to maintain one’s proportional interest in the corporation through purchase of additional common stock if and when it is issued.

Common Stock

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Preferred Stock

The title “preferred” stock is

somewhat misleading.

Preferred isn’t better; it’s different.

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• Preferred stockholders are entitled to receive their full cash dividend before any cash dividend can be issued to common stockholders.

• If the company goes bankrupt, preferred stockholders are entitled to have their investment repaid in full, before common stockholders receive anything.

Preferred Stock

The protection enjoyed by preferred stockholders is:

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Preferred Stock

CumulativeHas the right to receive accumulated dividends before any dividends may be paid to common stockholders.

Non-Cumulative

Has no right to “passed”dividends.

ParticipatingHas claim to a portion ofcommon dividends afterreceiving preferred dividends.

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Callable Permits the issuing companyto redeem the preferred stock.

RedeemablePermits the holder to redeem thestock--usually with somerestrictions.

ConvertiblePermits the holder to exchangepreferred stock for common stock.

Preferred Stock

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Issuance of Capital Stock

Goode Corporation issued 4,000 shares of $1 par common stock on April 1, 2002, for $45,000 cash.

Apr. 1 Cash 45,000Common Stock 4,000Paid-In Capital in Excess of Par 41,000

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Issuance of Capital Stock

Goode Corporation issued 4,000 shares of no-par common stock with a stated value of

$1 on April1, 2002, for $45,000 cash.

Apr. 1 Cash 45,000Common Stock 4,000Paid-In Capital in Excess of Stated Value 41,000

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Issuance of Capital Stock

On April 1, Goode Corporation issued 4,000 shares of no-par common stock

without a stated value on April1, 2002, for $45,000 cash.

Apr. 1 Cash 45,000Common Stock 45,000

17Capital Stock Sold on Subscription

On November 1, 2002, a firm received subscriptions for 5,000 shares of $1 par common at $12.50 per share with 50%

down, balance due in 60 days.Nov. 1 Cash 31,250

Common Stock Subscription Receivable 31,250

Common stock Subscribed 5,000Paid-In Capital in Excess of Par 57,500

18Capital Stock Sold on Subscription

On December 9, received balance due on one-half of subscribers and issued stock to fully paid subscribers, 2,500 shares.

Dec. 9 Cash 15,625Common Stock

Subscription Receivable 15,625

Common stock Subscribed 2,500Common Stock 2,500

19Stock Issued for Consideration Other Than Cash

AC Company issues 200 shares of $0.50 par value common stock in return for

land. The company’s stock is currently selling for $50 per share.

Dec. 5 Land 10,000Common Stock 100

Paid-In Capital in Excess of Par 9,900

20Stock Issued for Consideration Other Than Cash

Assume that the land has a readily determinable market price of $12,000, but AC Company’s common stock has

no established fair market value.

Dec. 5 Land 12,000Common Stock 100

Paid-In Capital in Excess of Par 11,900

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Stock RepurchasesTo provide shares for incentive

compensation and employee savings plans.To obtain shares needed to satisfy requests

by holders of convertible securities.To reduce the amount of equity relative to

the amount of debt.To invest excess cash temporarily.

Why Why repurchase repurchase

shares?shares?

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Stock RepurchasesTo remove some shares from the open market

in order to protect against a hostile takeover.To improve per-share earnings by reducing the

number of shares outstanding and returning inefficiently used assets to shareholders.

To display confidence that the stock is currently undervalued by the market.

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Treasury Stock

• Stock issued by a corporation but subsequently reacquired by the corporation and held for possible future reissuance or retirement.

• Reported as a contra-equity account, not as an asset.

• Does not create a gain or loss on reacquisition, reissuance, or retirement.

• May decrease Retained Earnings, but cannot increase it.

24Treasury Stock--Example:Both Accounting Methods

Issued 100, $10 par value shares at $15 per shareCost Method

Cash 1,500 Common Stock. 1,000 Paid-In Capital in Excess of Par 500

Par Value MethodCash 1,500 Common Stock 1,000 Paid-In Capital in Excess of Par 500

25Treasury Stock--Example:Both Accounting Methods

Reacquired ten shares at $16 per share.

Cost MethodTreasury Stock 160 Cash 160

Par Value MethodTreasury Stock 100Paid-In Capital in Excess of Par 50Retained Earnings 10 Cash 160

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Sold two shares of treasury stock at $20 per share.Cost Method

Cash 40 Treasury Stock 32 Paid-In Capital from Treasury Stock 8

Par Value Method Cash 40 Treasury Stock 20 Paid-In Capital in Excess of Par 20

Treasury Stock--Example:Both Accounting Methods

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Sold five shares of treasury stock at $14 per share.Cost Method

Cash 70Paid-In Capital from Treasury Stock 8Retained Earnings 2

Treasury Stock 80 Par Value Method

Cash 70 Treasury Stock 50 Paid-In Capital in Excess of Par 20

Treasury Stock--Example:Both Accounting Methods

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Retired remaining three shares of stock.Cost Method

Common Stock 30Paid-In Capital in Excess of Par 15Retained Earnings 3

Treasury Stock 48

Par Value Method Common Stock 30 Treasury Stock 30

Treasury Stock--Example:Both Accounting Methods

29Stock Rights, Warrants, and Options

Stock rights--Issued to existing shareholders to permit them to maintain their proportionate ownership interests when new shares are to be issued.

Stock warrants--Sold by the corporation for cash, generally in conjunction with the issuance of another security.

Stock options--Granted to officers or employees, usually as part of a compensation plan.

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Stock Warrants

Stewart Co. sells 1,000 shares of $50 par preferred stock for $58 per share. Stewart Co.

gives the purchaser detachable warrants enabling the holders to subscribe to 1,000 shares of $2 par common stock for $25 per

share. Immediately following the issuance of the stock, the warrants are selling for $3, and

the fair market value of a preferred share without the warrant attached is $57.

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Stock Warrants

Value assigned to

warrants=

Total issue price

xMarket value of warrants

Market value of security

without warrants

+ Market value of warrants

$57 + $3

Value assigned to

warrants= $58,000 x $3 = $2,900

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Stock Warrants

The entry on Stewart’s book to record the sale of the preferred stock with

detachable warrants is:

Cash 58,000Preferred Stock, $50 par 50,000 Paid-In Capital in Excess of Par--Preferred Stock5,100Common Stock Warrants2,900

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Stock Warrants

If the warrants are exercised, the entry to record the issuance of common stock is:

Common Stock Warrants 2,900Cash 25,000

Common Stock, $2 par 2,000 Paid-In Capital in Excess of Par--Common Stock25,900

Stock-Based CompensationAll employees eligible?

Shares offered equally?

Reasonable exercise period?

Exercise Prices » Market Price?

NoYes

Yes

Non-compen-satory Plan

Record sharesissued when stock

is purchased.

No

No

No

Compensatory Plan

Determine compensationexpense; amortize

over period employeeis to provide service.

No

Grant andMeasurementdates same?

Yes

Number of sharesand Exercise Price

known?

Estimate compensationexpense; amortize

over period employeeis to provide service.

Determine actual expense;amortize over remaining

period employee is toprovide service.

Record shares issuedwhen stock is purchased.

Adjust for UnearnedCompensation, if any.

No

Yes

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35Factors AffectingRetained Earnings

Error correctionsChanges in accounting principleNet incomeQuasi-reorganizations

RetainedEarnings

Increases

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Error correctionsPrior period adjustments

Treasury stockNet loss

Changes in accounting principlesDividendsRetained

Earnings

Factors AffectingRetained Earnings

Decreases

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Accounting for Dividends

• Declaration date: The date the corporation’s board of directors formally declares a dividend will be paid.

• Date of record: The date on which stockholders of record are identified as those who will receive a dividend.

• Date of payment: The date when the dividend is actually distributed to stockholders.

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Cash Dividend

ABC Corporation declares a $2,000 dividend; the following journal entries should be made:

Declaration DateDividends (Retained Earnings) 2,000

Dividends Payable 2,000Payment Date

Dividends Payable 2,000Cash 2,000

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Property Dividend

What is a property dividend?

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Property DividendIt is a distribution to stockholders that is

payable in some asset other than cash.

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Property Dividend

XYZ Corporation declares a dividend of 1,000 shares of Gondor, Inc. stock (cost

$3,000; fair market value, $5,000).

Date of DeclarationDividend (or Retained Earnings) 5,000

Property Dividends Payable 3,000Gain on Distribution of Property

Dividend 2,000

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Property DividendDate of Payment

Property Dividends Payable 3,000Investment in Gordor, Inc. Stock 3,000

Entry on the Books of a 50% ShareholderInvestment in Gordor, Inc. Stock 2,500

Dividend Revenue 2,500

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Stock Dividends: Small or Large?

• Small– Less than 20-25% of the outstanding shares.– Debit Retained Earnings for the MARKET

value of the shares.• Large

– Greater than 20-25% of the shares outstanding.– Debit Retained Earnings for the PAR value of

the shares.

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• Assume the following about Gean, Inc.:– Common stock ($2 par, 10,000

shares outstanding) $20,000– Additional paid-in capital $24,200– Retained earnings $12,500– Stock dividend declared 1,500 shares– Market price of stock $10/share

Example 1: Stock Dividend

• Assume the following about Gean, Inc.:– Common stock ($2 par, 10,000

shares outstanding) $20,000– Additional paid-in capital $24,200– Retained earnings $12,500– Stock dividend declared 1,500 shares– Market price of stock $10/share

Is this a large or small stock dividend?

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• Assume the following about Gean, Inc.:– Common stock ($2 par, 10,000

shares outstanding) $20,000– Additional paid-in capital $24,200– Retained earnings $12,500– Stock dividend declared 1,500 shares– Market price of stock $10/share

Example 1: Stock Dividend

Because 1,500 shares represent 15% of the

outstanding stock, it is a small stock dividend.

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Declaration DateRetained Earnings 15,000

Stock Dividends Distributable 3,000Paid-In Capital in Excess of Par 12,000

Example 1: Stock Dividend

Issuance DateStock Dividends Distributable 3,000

Common Stock 3,000

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Example 2: Stock Dividend

• Assume the following about Gimli’s Corp.:– Common Stock ($5 par, 20,000

shares outstanding) $100,000– Additional Paid-In Capital $100,000– Retained Earnings

$52,000– Stock Dividend Declared 10,000 shares– Market Price of Stock $20/share

Is this a large or small stock dividend?Is this a large or small stock dividend?50% = large dividend50% = large dividend

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Example 2: Stock Dividend

Declaration DateRetained Earnings 50,000

Stock Dividends Distributable50,000

Issuance DateStock Dividends Distributable 50,000

Common Stock50,000

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Liquidating Dividend

A liquidating dividend is a distribution representing a return to stockholders of a

portion of contributed capital.

50Disclosures Related to the Equity Section

Authorized but unissued. Subscribed for and held for issuance pending

receipt of cash for the full amount of the subscription price.

Outstanding in the hands of stockholders. Reacquired and held by the corporation for

subsequent reissuance. Canceled by appropriate corporate action.

Capital stock may be:

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Quasi-Reorganization

Where state law permits, a company may eliminate a deficit through a

restatement of invested capital balances. This provides a fresh start

for the company with a zero balance in Retained Earnings.

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Quasi-ReorganizationBalance Sheet for Anon., Inc. Before Quasi-Reorganization

Current assets................................ $ 250 Land, building, and equipment........ 1,500 Accumulated depreciation............... (600) Total assets................................…. $ 1,150 Liabilities......................................... $ 300 Common stock ($10 par, 100 shares) 1,000 Retained earnings........................... (150) Total liabilities and equity............ $ 1,150

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Quasi-Reorganization Plan for Anon., Inc.• Reduce land, building, and equipment to

fair market value of $600.• Reduce par value of stock to $5; create

$500 of “additional paid-in capital.”• Apply $450 deficit ($150 from Retained

Earnings and $300 from fixed asset revaluation) against Paid-In Capital.

Quasi-Reorganization

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Journal Entries for Anon., Inc.Quasi-Reorganization

Fixed Asset RevaluationRetained Earnings 300Accumulated Depreciation 200

Land, Building, and Equipment500

Quasi-Reorganization

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Revalue Common StockCommon Stock, $10 par 1,000

Common Stock, $5 par 500Paid-In Capital from Stock Revaluation 500

Quasi-Reorganization

Erase DeficitPaid-In Capital 450

Retained Earnings 450

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Balance SheetAfter Quasi-Reorganization

Current assets..................................... $ 250 Land, building, and equipment............ 1,000 Accumulated depreciation................... (400) Total assets....................................... $ 850 Liabilities.............................................. $ 300 Common stock ($5 par, 100 shares)... 500 Paid-in capital...................................... 50 Total liabilities and equity.................. $ 850

Quasi-Reorganization

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The End